The conventional wisdom is that lower interest rates stimulate economic activity, and higher rates dampen it. But new research casts doubt on this hypothesis.
It is widely believed that there is a negative correlation between interest rates and growth. That conventional wisdom explains the policy actions of central banks which, to stimulate real economic activity, from 2008 through 2022 repeatedly reduced nominal policy interest rates, even to zero or negative territory. The conventional wisdom is so accepted that there has been little research examining the relationship.
In their study, "Are lower interest rates really associated with higher growth?," authors Kang-Soek Lee and Richard Werner tried to answer that question. New empirical evidence on the interest rate thesis from 19 countries,” published in the October 2023 issue of the International Journal of Finance and Economics, examined the link between nominal interest rates – a key target of central bank action – and real economic growth. Their data sample covered developed and emerging market economies, using industrial production as a monthly indicator of real economic activity and three types of nominal interest rates: the overnight call rate, the three-month interbank rate and the 10-year government bond yield. Their sample period varied depending on data availability from central banks or the International Monetary Fund. The longest sample covered industrial production in the U.S. from 1955 through March 2015, and the average data period was 30 years. Following is a summary of their key findings:
- In contrast to the conventional wisdom, the relationship between the overnight call rate and industrial production was positive in most periods, turning negative in those that tended to coincide with crisis episodes. For example, the U.S. showed a close-to-minus-one correlation when a crisis occurred (e.g., the oil price shocks of 1973-1974 and 1979-1980; the U.S. banking crisis of 1982-1983; the recession of 1991 due to the Fed's monetary restriction; the dotcom bubble bursting in 2001-2002, and the subprime and global crisis of 2008–2009). But most of the time, the correlation was highly positive (close to one) and remained relatively stable. Thus, lowering interest rates is not likely to be effective in stimulating the economy except during crisis periods.
- The relationship between the three-month rate and industrial production was positive in most periods but negative in times of crisis in virtually all countries examined.
- The relationship between economic growth and the 10-year government bond yield rate was even more strongly positive than for the overnight and three-month rates, confirming the general finding that the correlation was positive in most periods and negative in times of crisis.
Causality
Lee and Werner then ran Granger causality tests (a statistical hypothesis test for determining whether one time series is useful in forecasting another) and found that the conventional wisdom that interest rates and growth are negatively correlated and causation runs from rates to growth was not generally supported by the data – the correlation was positive in most countries, and/or the causality was more likely to run from economic growth to interest rates when the correlation was negative.
Lee and Werner concluded: “Our empirical findings reject the theoretical argument that interest rates affect economic growth causally, and in an inverse manner.” They added: “Our empirical results show that (1) the correlation between economic growth and interest rates is not negative but positive in virtually all countries examined over most time periods, and; (2) when significant, the majority of evidence suggests that the causal link does not run from interest rates to economic growth, but more likely from economic growth to interest rates; (3) the findings apply also to the period before the 2008 crisis. We believe these results hold for both industrialized and emerging market economies. This means that monetary policy confined to lowering or raising interest rates cannot be effective in moving the economy in the claimed direction, and that this could be a general result applying not just to a post-crisis situation.”
Investor takeaways
Lee and Werner’s findings are consistent with the view of the Department of Commerce, which does not consider interest rates as either a leading or coincident economic indicator. Instead, it has long considered interest rates to be a lagging indicator of economic growth. The 10 lagging indicators of economic activity used by the Commerce Department are unemployment rate, inflation rate, inventory to sales ratio, corporate profits, labor cost per unit of output, interest rates, bankruptcy rate, consumer confidence, housing starts and new vehicle sales.
Lee and Werner’s findings cast doubt on the wisdom of the long-standing conventional monetary policy of attempting to stimulate economic growth by lowering nominal rates and dampen growth and inflationary pressures by raising rates. They explained: “Our evidence shows that policy-makers aiming at higher economic growth should instead be looking to arrange for interest rates to be moved higher. Our simplest intuition for these findings is via the effect of a steepening yield curve, which would render supplying credit for business investment more attractive for banks – undoubtedly a positive factor for output and growth, as well as financial stability. On the other hand, lowering short rates and pushing long rates down flattens the yield curve and drives banks to lend for asset purchases (or drives them out of business), hurting economic growth.” They added: “High rates and/or a steeper yield curve may trigger a larger quantity of bank credit being released by banks, outweighing any potential negative effect of higher rates (such as fewer projects being able to demonstrate positive NPV).”
The misconceptions about interest rates and their effects explains why it is very difficult to make accurate economic forecasts – trying to time markets based on economic forecasts is a loser’s game.
Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC.
For informational and educational purposes and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based on third party data and may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, and confirmed the adequacy of this article. LSR-23-591
A message from Advisor Perspectives and VettaFi: Advisors: You're Invited to Exchange!Nothing would be a better start to the new year than if you joined us at Exchange, an in-person conference for members of the financial services community in Miami, Florida on February 11-14th. For a limited time, we're offering you a free Exchange ticket!* Register today with code WINTER24 to claim your pass.
Read more articles by Larry Swedroe
The conventional wisdom is that lower interest rates stimulate economic activity, and higher rates dampen it. But new research casts doubt on this hypothesis.
